Conventional economics often ignores the effects of debt, but at high levels it can become quite powerful. Government deficits are inflationary, and if higher interest rates are paid with higher deficits then this can spiral out of control like it often does in emerging markets.
Example: A government with 200% debt to GDP raises interest rates to 20% to combat inflation. Most government debt is issued at short durations, and is very money-like in itself being used for payments on large transactions. This government must now pay 40% of GDP on interest expense alone. This involves heavy increases in money supply which causes hyperinflation. Emerging market nations such as Argentina understand this better than the IMF, but they ultimately have no choice but to accept their prescriptions.
Note that there are powerful anti-inflationary affects of forcing interest rates higher, such as causing a contraction in bank lending and offering better incentives for investors to hold the currency. However, these effects can be outweighed by debt just like atomic forces are outweighed inside a star.
Does this apply to the US?
Not yet. US Federal debt to GDP is 129%, so every interest rate hike does widen the deficits considerably. However, the powerful deflationary forces can be seen throughout the banking sector. Bank Failures:
Reduced demand for discretionary goods:
Banks are also pulling back on lending in a number of sectors including auto loans. This includes both consumer auto financing, particularly for new vehicle purchases, and floor loans which are lent to dealerships so that they can acquire inventory to sell. Here’s one such article: https://www.newsnationnow.com/business/banks-auto-lending-car-dealerships/
Higher interest rates also affect corporate and consumer debt very differently than government debt, because these entities can’t just expand spending to cover the higher interest payments.
When commercial debt rolls over, a bank or banks have to agree to re-lend this debt. In some cases this just means higher interest rates which the company may or may not be able to afford. In other cases, the banks are simply not willing to finance the whole extent of the previous debt so the company has to come up with the difference or default on the loan. This is particularly relevant with asset-backed debt such as an office tower. If the value of the underlying assets drops considerably, or the interest coverage ratio plummets because income didn’t go up with interest rates, then banks won’t roll over the loans without a significant payment from the company, and the loan ends up in default.
Consumer debt is a bit different from corporate debt, in that it is often shielded from sharp rate increases and payment plans end with payoff rather than a planned refinancing date. As a result, interest rates alone don’t tend to spark consumer debt defaults – layoffs is the big driver. Higher interest rates do have a dampening effect on bank willingness to extend new credit however, so this does have a slowing effect. In other countries with high amounts of variable interest rate loans, rate hikes have a much bigger impact on consumers.
Where do things go from here?
There were a couple of interviews which really made me think about the current situation.
Chris Whalen gives his most condensed take here:
Chris describes the scenario where interest rates were thoroughly repressed in 2020 as US rates hit zero, European and Japanese rates went negative, and the Federal Reserve was buying up large amounts of mortgage-backed securities. Then massive fiscal stimulus put an incredible amount of deposits into the banking system, just as every mortgage borrower in the US was heavily incentivized to refinance at rock-bottom interest rates. Banks are in the business of lending their deposits, and they invested heavily, particularly in loans with low credit risk such as mortgage-backed securities and treasuries, but ultimately into any loans they could get their hands on as Powell was urging them on saying that interest rates will remain low for a very long time and they aren’t even thinking about thinking about raising rates. While some bankers were skeptical, like Jamie Dimon who kept JPM’s duration down around 3 years, many pushed the envelope like First Republic with a huge book of non-conforming mortgages on high end properties at 3% interest rates with no principle payments for 5 to 10 years.
When Powell raised rates at the fastest pace in history, going from 0% to 5% in just over a year, these banks were stuck with loans and securities that lost an enormous amount of market value. They can be held to maturity safely if they can keep deposits at 0% while slowly earning the 3 % to 4% yields on their longer duration debt, but a small amount of sales would push the equity value of the bank negative and throw them into FDIC receivership. Meanwhile, regular depositors are eying money market rates up to 5% and moving their savings while large depositors are worried about that $250k FDIC insurance limit if they don’t move their operations to one of the too-big-to-fail superbanks.
The Federal Reserve reacted by allowing large amounts of borrowing from the Federal Home Loan Bank, their traditional discount window, and a new facility called the Bank Term Funding Program. These programs all lend money secured by the bank’s loan and financial security assets, and the BTFP would even lend up to 100% par value on government-backed securities which is more than the current market value. This alleviates a spiraling crisis as banks can meet any deposit withdrawals using these programs without having to sell off their assets and incur big losses.
Although these government facilities stopped the immediate crisis, they only really delayed the problem. Why? Banks borrowing from these facilities are doing so around the Fed Funds Rate – so they are earning money from long-term loans at rates around 3-4% while paying around 5% interest to the federal reserve. They still face steep losses on any loans they sell, and their capital position is eroding over time.
The analogy that I like to use here is that the Federal Reserve is holding the regional banks under water while trying to prevent them from all drowning at once.
So why is Powell doing that? Is he trying to consolidate the banking system into a much smaller number of bigger banks that are easier to influence? To what end? That is where the second interview comes in:
Danielle describes Powell as an intelligent man with prior experience working at a hedge fund, who knows very well what he is doing. He understands that the job openings data is bogus, and that the economic indicators he touts are the most lagging for various reasons, but he will say whatever he needs to in order to keep interest rates as high as possible for as long as possible. He is on a mission that goes beyond simple CPI inflation, and he cites Paul Volker, who caused a major double-dip recession in 1980-1983, as his guiding light.
During the global financial crisis in 2008, the government decided to take much more regulatory control over the banking system to prevent them from causing the excesses that led to the GFC. However, most of the big players in banking at the time decided not to play ball. These bankers formed large hedge funds or shadow banks which would use enormous amounts of leverage while avoiding the new banking regulations. This activity was aided and abetted by low interest rate policies, an endless stream of QE operations, and the direct involvement of the Federal Reserve in the Repo markets.
The results of the high-leverage activities above were ballooning asset valuations leading up to the current “everything bubble” as stocks, bonds, and housing prices shot endlessly higher. This caused the asset-holding class to gain enormous wealth and hoard assets while ordinary citizens saw basic costs of living like rents shoot ever higher.
Here are a couple of charts which back that view, taken from Nick Gerli’s interview with Adam Taggart of Wealthion:
This chart shows more homes per capita in the US than at any point in the last 60 years in blue. The green line, homes per employed person, is above average but tends to spike when unemployment is high.
This chart is just as crazy, showing the tiny sliver of US homes for sale versus a much larger number of vacant homes and the total US single family homes at the bottom. An astounding 14% of homes are vacant! Why is that? Some are vacation homes, some are acquired by wealthy overseas investors who want a foothold in the country, but an ever-increasing number are investment homes, many of which are used for short-term rentals with services such as AirBnB.
Now back to Powell.
Jerome Powell knows how much pressure he is putting on anyone with excessive leverage right now, and that’s what he’s aiming to crush. He wants to see a wave of defaults which brings asset prices cascading down to the more reasonable levels we saw in the past.
Whether Powell’s cause is noble or not, it will have enormous effects on asset values going forward. The banking system is the tip of the iceberg here, and many of the entities that these policies are gunning for don’t have direct access to central bank financing. It is often said that central banks will hike until they break things, and things are breaking, but not quite enough to change policy.
Alternate Viewpoint leading to our current situation based on trade:
I recently finished Michael Pettis’s book “Trade Wars are Class Wars,” where he describes the effects of open trade with mercantilist policies. Here’s my quick-and-dirty overview of the situation.
Many countries in the world want to become wealthy, but they lack sufficient infrastructure and the competitive industries which require massive investment. They start subsidizing export-oriented businesses while suppressing their costs using a wide variety of methods, which essentially result in less income for wages and more income for the exporting industries. These policies helped Japan, then South Korea, then China grow at incredible rates while building first-rate infrastructure.
Unfortunately, it is very difficult for a country which embraces mercantilist policies to ease off and allow demand to increase domestically. The policies have fantastic initial results and provide excessive benefits to a class of powerful interests. Those who benefit are able to gain tremendous wealth by acquiring assets abroad at the expense of an increasingly underpaid workforce. Any attempts to re-balance the situation also lead to the immediate erosion of export competitiveness, which harms industries plagued with overcapacity. However, productive investments have all but dried up leaving ever more speculative projects and speculations such as the “ghost cities” scattered around Japan as well as China.
Germany has been a mercantilist powerhouse for many decades post WW2. After reunification, they doubled down on such policies to the extent that they had higher average income but lower median income than most of their neighbors. Before the GFC, their policies were coming under question, but post GFC their low government debt levels allowed them to impose their views and policies on much of the Eurozone. As a result, European bloc countries are strong net-exporters all while suppressing wages and demand back home.
Bring in the US. Clinton turned the country heavily towards “free trade” in the 1990’s with NAFTA, followed by Bush inviting China into the WTO and Obama moving to further trade pacts like the TPP. With a strong free-trade push combined with open capital markets featured by comparatively strong protections for foreign asset-holders and topped with the world’s reserve currency, the US became the dumping groud for trade surpluses worldwide as we outsourced the bulk of our manufacturing sectors and trade deficits soared. Wealth from trade surpluses abroad was increasingly re-invested in the US, shooting asset markets ever higher. Before the GFC, our financial sector got creative with new instruments like mortgage-backed securites to sell to an endless supply of foreign investors. After the GFC, the government-backed markets drew much more of the investment and foreign entities started holding US paper even at near-zero rates and then diversifying into US stock index funds, commercial real estate, and housing. Interest rates were rock bottom even as wages went nowhere and financial assets soared.
The viewpoint above for the increased value of US financial assets above all others makes a lot of sense to me, and it makes me think that Powell will ultimately fail in popping the US “everything bubble.”
I believe that we will continue to see bank defaults in coming months, along with more private sector funds we never heard of like Archegos in 2021 or Three Arrows Capital in 2022. The trickle of defaulted commercial real estate will continue as well, and banks will continue tightening credit to businesses as consumer demand remains constrained. I believe this will lead to a spike in unemployment which is impossible to ignore, just like the ones we saw after every other Fed tightening cycle, as many of the businesses which just recovered from the post-pandemic labor shortages lay off their newest employees again.
Then policital atmosphere will change dramatically as calls to replace Powell emerge and the Fed Funds rate goes down towards zero. As for fiscal stimulus, it could go any which way for a while as we enter an election year with a divided congress that will be frantically blaming the other side for all ills – as we see now with the debt ceiling. Regardless, they’ll eventually scramble for stimulus like in 2020 if they feel the need.
Ultimately, we have destroyed an enormous amount of supply capacity in the past few years with pandemic lockdowns, the rapid and permanent closure of nuclear plants and cancellation of oil and gas projects, the shuttering of large industrial capacity for fertilizer and aluminum and such, and the populist pressures we see throughout South America dropping mining capacity further. Once we saw the lagged measures of rapid inflation alongside pandemic re-opening, we started fighting it almost completely with demand-side measures.
Any attempts to bring back a normal level of growth will hit that supply wall even sooner until we finally make a real push to re-build supply capacity.
This is ultimately my thesis for a decade of outsized returns to commodities, and the reason why I’m piled into mining stocks. It takes many years and a lot of investment to develop a mine. For the past decade, this sector has been financially strained as the overcapacity from the boom through 2011 finally worked through. We’re approaching the time where prices will soar without new production, and current prices aren’t enough to incentivize that production. It will be a rough ride, and I sold a lot of covered calls expiring as late as January 2024 expecting a tough year in the sector, but it is a very small sector that can shoot up fast when investment money starts flowing in.
I’ll end it here. These are my current allocations. Note that I added a bit to my AAPL puts.
- HEDGES (6.3%)
- TLT Calls (4.0%)
- LEN Puts (0.6%)
- AAPL Puts (1.3%)
- TSM Puts (0.5%)
- PRECIOUS METALS (39.6%)
- AG w/ cc (5.8%)
- EQX w/ cc (5.2%)
- MTA w/ cc (4.4%)
- SILV w/ cc (4.5%)
- LGDTF (3.0%)
- SLVRF (4.2%)
- SAND w/ cc (2.6%)
- MMNGF (2.7%)
- SSVFF (2.0%)
- BKRRF (1.6%)
- RSNVF (1.3%)
- DSVSF (1.3%)
- HAMRF (1.1%)
- URANIUM (22.1%)
- CCJ w/ cc (4.0%)
- DNN (3.1%)
- DNN calls (1.6%)
- UUUU w/ cc (3.8%)
- UEC w/ cc (2.8%)
- UROY (3.0%)
- LTBR w/ cc (1.5%)
- EU (1.7%)
- BQSSF (0.7%)
- BATTERY METALS (15.0%)
- NOVRF (5.5%)
- SBSW w/ cc (4.8%)
- EMX (3.1%)
- PGEZF (1.7%)
- US CANNABIS (9.8%)
- GTBIF (1.9%)
- VRNOF (1.7%)
- TCNNF (1.3%)
- TRSSF (1.3%)
- CRLBF (1.3%)
- CURLF (1.3%)
- CCHWF (0.5%)
- AYRWF (0.6%)
- OTHER (5.4%)
- DOCN w/ cc (2.0%)
- XRP (3.4%)
- CASH (2.0%)
Thanks for the article, I like the incorporated video’s.
I’m not sure why you think Powell is trying to pop the everything bubble (completely), or maybe I misunderstood. If he succeeds in getting more banks to fail and higher unemployment then surely he succeeds in at least partially popping asset prices and so also at least partially get inflation back under control. Isn’t that what he’s so determined to do?
Won’t the political pressure on him be greatest if he fails to get inflation under control and more and more people start to see that their wages are not going to catch up anytime soon? I can’t see any popular support for a scramble to stimulus with inflation as far above 2% as it is and with debt at historical highs.
I don’t know if you still read him but Wolf Richter has a similar view.
My current views actually line up a lot more with Michael Pettis and Jeff Snider.
I don’t think Powell will succeed in popping the everything bubble, but I do think he’s trying. He sees a market driven by the Fed and QE, while I believe that QE is generally irrelevant and markets are driving rates. The Fed is rates higher with RRP, but they would naturally fall back towards zero if left alone regardless of deficits.
Our world is plagued today by the persistence of classical “common sense” economic ideas saying that investment is always good, debt is always bad, and spending should always be curbed to fund investment.
Asian economies epitomize this with generally weak consumer demand as wages are suppressed and businesses are subsidized. Japan hit a wall first, as could no longer get gains from bullet trains and such while consumer demand remained repressed – they’ve essentially been in a depression since 1990. Then South Korea hit that wall, and now China is hitting that wall. Yet they still overtax labor and subsidize business creating permanent trade surpluses.
European economies have all pushed towards the same policies after the GFC, with big VATs and fights to reduce worker pay and benefits as more and more of their workers are permanently part-time. They worked towards permanent trade surpluses as well, though their destruction of nuclear power plants and wasteful spending on wind and solar have hampered that more recently as it caused major energy shortages.
That leaves the Anglo countries – US, Canada, Australia, UK – as the major economies with open capital markets and free trade, and these have become markets for trade surpluses and dumping grounds for foreign investment. This is particularly true of the US due to it’s size. As a result, the US has a permanent trade deficit and capital surplus, so money is flooding into US investment assets even as labor sees intense competition and negative real wage growth.
The bulk of the inflationary trouble came after the pandemic, despite the deficits, low rates, and QE before. In addition, we see flat or falling real demand amid higher prices and companies are still strongly favoring stock buybacks over real investment. This tells me the inflation is caused by supply destruction, not excess demand.
Our problems can be fixed in a number of ways, but everyone is fixated on the debt levels, which are impossible to reduce by simply cutting spending. This actually makes things worse as corporations and consumers can’t keep borrowing, and consumers can’t compete with imports, so GDP collapses like we saw in Europe in the 2010’s are a result of that path.
We can reduce debt by focusing on the trade balance – using tariffs and subsidies to get our own industries going. That would at least work, but it brings the question- why focus on debt rather than growth and prosperity? If trade surplus countries want to buy US treasuries, US debt, and US stocks so bad then why not fix some of the critical infrastructure backlog that’s been building? Roads, nuclear plans, desalination, gas pipelines, refineries, and so on? Why not let consumers drive some of the investment ends too while becoming more competitive by reducing our taxes on labor and pulling more tax from corporations and imports?
Unfortunately we’re all victims of bad economic policies, and the worst thing is that these policies actually benefit the wealthy and drive the wealth divide, making it extremely difficult for them to see. That was Hillary Clinton’s mistake in 2016 – she came out bragging about how things were booming when most Americans felt like we never exited the 2008 recession. Yet most politicians on both sides of the aisle totally miss it.
The good news is that I am a firm believer in the need to build mines like crazy after more than a decade of non-investment. Uranium in particular looks amazingly bullish in coming years, and almost everything I hear about that sector is good news. Even as Stolz shut down their last nuclear plants, Trudeau and even Newsom have come round to embrace a nuclear future while the Japanese try to restart plants as fast as they can.
Interesting times ahead.